Commercial Bank Accounting Questions Flashcards
Explain the Allowance for Loan Losses and Provision for Credit Losses, where they show up on the 3 statements, and why we need them.
You need both of these items because banks expect a certain number of borrowers to default on their loans.
The Allowance for Loan Losses shows up as a contra-asset on the Balance Sheet, and is deducted from the Gross Loans number to get to Net Loans; it represents how much of the current Gross Loans balance the bank expects to lose (i.e. borrowers default).
The Provision for Credit Losses number is an expense on the Income Statement; it represents how much the bank expects to lose on loans over the next year (or quarter, or month, depending on the period) above and beyond the Allowance for Loan Losses.
Increasing the Provision for Credit Losses increases the Allowance for Loan Losses (technically it decreases it because it’s a contra-asset) and vice versa.
Let’s say we record a Provision for Credit Losses of $10 on the Income Statement. What happens on the other statements?
Income Statement: Pre-Tax Income would go down by $10 and Net Income would fall by $6 if you assume a 40% tax rate.
Cash Flow Statement: Net Income is down by $6 but the Provision for Credit Losses is a non-cash expense, so we add it back, and overall Cash is up by $4.
Balance Sheet: Cash is up by $4 on the Assets side, but the Allowance for Loan Losses has now decreased by $10 (remember, it’s a contra-asset: if it was negative $5 previously, it would be negative $15 now), so overall the Assets side is down by $6.
On the Liabilities & Equity side, Shareholders’ Equity is also down by $6 because Net Income was down by $6 and it flows in directly, so both sides balance.
Our beginning Allowance for Loan Losses is $50. We record Gross Charge-Offs of $10, Recoveries of $5, and then add $10 to the Allowance for Loan Losses to account for anticipated losses in the future. What’s the ending Allowance for Loan Losses?
The math is simple, but the concepts can get confusing: to determine the ending balance, you take the beginning balance, subtract Gross Charge-Offs (those are the actual loans that borrowers defaulted on), add Recoveries (those are previously written off loans that you can partially recover due to collateral), and then add any additional provisions.
So in this case, $50 – $10 + $5 + $10 = $55.
Remember that this is a contra-asset, so it would appear as negative $55 on the Assets side of the Balance Sheet.
Let’s continue with this scenario. Walk me through what happens on the 3 statements when you have Gross Charge-Offs of $10, Recoveries of $5, and an addition of $10 to the Allowance for Loan Losses.
First, realize that this “addition of $10 to the Allowance for Loan Losses” really just means “$10 of Provision for Credit Losses.” The interviewer is using tricky wording here to disguise what’s going on.
Income Statement: Only the Provision for Credit Losses shows up. So Pre-Tax Income falls by $10, and Net Income falls by $6 if you assume a 40% tax rate.
Cash Flow Statement: Net Income is down by $6, and we add back the $10 Provision for Credit Losses so Cash is up by $4 at the bottom. Gross Charge-Offs and Recoveries do not show up on the Cash Flow Statement.
Balance Sheet: Cash is up by $4, the Gross Loans balance is down by $5 because there was $10 in Gross Charge-Offs plus Recoveries of $5, and the Allowance for Loan Losses is now negative $55 rather than negative $50. Overall, the Assets side is down by $6.
On the other side, Shareholders’ Equity is down by $6 because Net Income decreased by $6, so both sides balance.
Why does the Net Charge-Offs number (Gross Charge-Offs – Recoveries) not show up on the Cash Flow Statement?
Because it cancels itself out: it reduces the Gross Loans number, but it increases the Allowance for Loan Losses, so the Net Loans and Total Assets numbers stay the same.
Let’s say we have Gross Charge-Offs of $10 billion. Walk me through what happens on the 3 statements.
Trick question – there are no net changes. For banks, only the Provision for Credit Losses actually impacts the financial statements.
What they have actually written off does not change anything – only what they expect to write off does.
There would be no changes on the Income Statement or Cash Flow Statement for this scenario.
On the Balance Sheet, Gross Loans would decrease by $10 billion and the Allowance for Loan Losses would increase by $10 billion, so the two cancel each other out and the Net Loans number stays the same, as do both sides of the Balance Sheet.
Wait a minute. You’re telling me that if a bank writes off $10 billion worth of loans, nothing is affected? How is that possible?
Nothing in the current period is affected. If a bank had write-offs this large, they would need to increase their Provision for Credit Losses in future years.
So the next year, you might see a Provision for Credit Losses of closer to $10 billion, which would impact the financial statements.
A bank must disclose all these numbers in its filings, so if it did not increase its Provision for Credit Losses appropriately, investors would start running for the hills.
What ratios can you use to analyze a bank’s charge-offs?
There are dozens of ratios involving charge-offs, but the 4 most important ones are:
• NCO Ratio: Net Charge-Offs / Average Gross Loan Balance
• Net Charge-Offs / Reserves: Net Charge-Offs / Allowance for Loan Losses
• Reserve Ratio: Allowance for Loan Losses / Gross Loans
• NCO / Prior Year Provision: Net Charge-Offs / Last Year’s Provision for Credit Losses
The meaning for each of these is fairly intuitive – the percentage of loans you’ve charged off, what you’ve charged off relative to what you expected, what percent of loans you expect to lose, and how accurate your predictions from the year before were.
Other metrics include NPLs (Non-Performing Loans) – those currently in default or in violation of covenants – and NPAs (Non-Performing Assets), which is just NPL + certain foreclosed real estate properties (the official name is OREO – not the cookie, but Other Real Estate Owned Assets).
From these you could create the NPL Coverage Ratio – Allowance for Loan Losses / NPL – and the NPA Ratio – NPA / NPL.
